3. The accrual basis states that revenues be recognized when earned and
expenses be recognized when incurred. Specifically, revenues are recorded in
accounting financial statement right when transactions occur (goods/services
are sold/rendered to customers) and expenses are recorded right when related
good/services are used, regardless of when cash is exchanged. Under accrual
basis, revenues are matched with the expenses incurred to generating that
revenue. The aim of this is to measures the overall profitability of the
company by easily offset revenues with its the related expenses.
In contrast to accrual basis, cash basis of accounting mainly concerns
about the cash flow. Cash accounting is introduced as an accounting method
where revenues/expenses are recognized when cash is received/paid. The
profitability of a business is measured as a cash balance from its initial
state to its final state. The cash basis accounting has limited application for
small business such as local retailer, pharmacy, food court while accrual basis
is widely employed for most of business. Moreover, Generally Accepted
Accounting Principle (GAAP) considers the accrual basis as part of it instead
of cash basis principle.
Matching principle dictates that all the revenues and the expenses that
incurred to generate those revenues should be recorded parallelly at the same
accounting period. The properly periodic reflect revenues and expenses is
beneficial to process of adjustment. To illustrate the matching principle, there
is an example.
Company A Ltd is
manufacturing business that sells uniform to local schools. Each of finished
uniform set, a company will charge at $20. Cost to producing each set including
raw textile, electricity, worker wages, etc is $3. In May, the factory produced
200 and sold 100 clothes sets. Calculating the revenue, it equals . To have the gross profit, cost is going to be
calculated. As matching principle, the related cost to make that revenues (100
sets of uniform) will be taken into account as . Gross profit is .
If the accountant
recorded expenses improperly in incorrect period, let say for a whole month of
May, expense is while revenue
is $2000, gross profit would be . At that point, gross profit is understated. Whenever
the matching principle is violated, gross profit may be either understated or
overstated and so are the balance sheet balances.
In summary, at the end
of May, factory’s net income is $1700 and the closing inventory (remaining good
unsold) value is recorded in SFP as current assets.
Under accrual basis accounting, there are four supporting principles
which are: Time Period Principle, Revenue Recognition, Expense Recognition and
Historical Cost Principle. They are discussed in the following section.
Time Period Principle or
Periodicity Principle is the concept that business and organizations are required
to produce financial statement report in an accounting periods of equal length,
which is usually monthly, quarterly or yearly. The regularly financial
reporting helps reflecting company economic activities at a point of time and
provides valuable information to the lenders and investors.
states that revenues should be recognized when a product has been sold or a
service has been delivered, regardless of when cash is received. Under revenue
principle, four criteria are required to be met to record revenues. First, company
must have performed goods delivery or services rendering to their customers. Second,
in exchange to the company performance, there must be a mutual agreement
between two parties and it plays a role as a proof to ensure payment process is
made or would be made in future. Third, prices and amount of collecting money
are fixed and determined. Fourth, there is reasonable expectation when the
payment is received. Reviewing customers’ creditworthiness can assure the
collection of payment. In general, these four criteria are met at the point of
goods or services delivery.
states that expenses should be recognized at the same accounting period with
the revenue that are earned as a result of those expense. Costs and revenues
are correlative. For example, for most business, buying supplies and selling
products may occur at different period of time. In May, a bookstore paid $ 10 to
buy a book and only can sell that book for $20 in a month later, June. At that case,
cost should only be recognized in the following month when the relating revenues
are earned. In addition, expenses are also recognized by the time asset is used
up or a liability is incurred. For example, purchases of office supplies or
prepaid subscription for a magazine.
Historical cost means
the actual cost at time of transaction. It is differentiated with current cost
or inflation-adjusted cost. For instance, the house is sold for $1 millions in
2014 and at current time, it was assessed as $1.2 millions. The cost or
historical cost $1 millions is recorded in the balance sheet even when the
current cost is now different. In summary, the accounting information is based
on actual cost.
2. Statement of financial position (SFP) or Balance Sheet
aim is to reflect the financial situation of a company at a specific point in
time. In balance sheet, resources controlled by the entity (assets) and sources
of funds of the entity (liabilities) are presented as well as stockholders’
equity in the business. A balance sheet may be prepared monthly, quarterly or
annually as required by the external or internal users. For company managers,
balance sheet assists them in making decision to achieve their business goals. All
that accounting information is to be shared internally. For external users such
as creditors, balance sheet helps them in evaluating company’s creditworthiness
so that debt is paid on time.
Framework for Financial Reporting, asset is defined as “a resource controlled
by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity”. Assets can be classified in
current asset or non-current asset. Current assets are cash or company assets
that can turn into cash within 12 months. They should be realized within normal
operating cycle and be hold for trading purpose. They are including account
receivables, inventory, prepaid expenses etc. All other assets are non-current,
that are long-term investment, real estate, equipment etc. A asset is
recognized on financial report when it meets the above definition. Apart from
that, asset must be inflow of economic benefits to the entity and its value
must be measurable.
“Liability is a
present obligation of entity arising from the past events, the settlement of
which is expected to result in an outflow from the entity of resources
embodying economic benefits” as defined by conceptual Framework. Liabilities
are separated into current liabilities or non-current liabilities. Current
liabilities are obligations that due within 12 months or normal operating cycle
and been hold for purpose of trading. For which, company cannot defer the
settlement over a year. They are comprising of account payables, accrued
expenses, unearned revenues, etc. All other liabilities are non-current, which
are long-term liabilities. A liability is recognized when the outflow of
resources embodying economic benefits is probable and the obligation value is
Equity is what the
stockholders hold after an accounting period and presents “the residual
interest in the assets of the entity after deducting all of its liabilities”. Equity
are contributed capital of the owner in initial state and added profits/losses
during business operations later on. Equity Accounts comprise owner’s capital,
owner’s withdrawals, Revenue and Expense, etc. For each legal form of business,
equities are recorded differently in financial statement.
proprietor business when a company is owned by one person, equity is presented
in one capital account. The capital account balance changes over the time as a
result of owner action such as investing cash/ assets into business or withdrawing
cash out of business and when the business itself makes a profit or incurs a
partnership business when a company has more than one owner, there are more
than one capital accounts. Each owner of partnership has his/her own capital
accounts to keep track of their investments. Similar to sole proprietor,
accounts’ balances are different at different point in time.
corporation, the shareholders’ investments made into the company are
illustrated in “share account” instead of capital account. There are classes of
share accounts including common share, preferred shares, capital surplus, etc. Additionally,
the contributed investments by owners are distinguished with the company
earnings over the year. Therefore, retained earnings account is introduced to
keep track of company’s earnings and all the dividends paid to company’s
The IFRS Framework
The IFRS Framework
specify how non-monetary assets and liabilities are measured and acknowledge
the importance of a class of measurement basis are used in financial statement
today. They are: historical cost, current cost, net realizable value and
present value. Historical cost is the most common used basis. Under historical
cost, asset value equal to the amount received in the transaction when asset is
purchased. Beside historical cost, current cost (mark-to-market) basis measures
fair value which is the asset sale price agreed between willing buyers and
sellers. When preparing accounting reports, historical cost basis will be combined
with other measurement bases at different extents depends on certain circumstances.
Statement of Comprehensive Income is to reflect the company performance
during an accounting period. The statement illustrates financial heath and
risks of the business and provide critical accounting information to users. For
investors, they look at the profitability of the company in order to ensure the
returns of their investments. For suppliers, they look for company’s
credibility to confirm the debt is paid on time. Depending on purposes of the
users, statement can be prepared for different period of time. Most of company
generate monthly income statement.
In statement of comprehensive income, the revenues earned by company
and the expenses incurred to generate those revenues are stated. By deducting
revenues over expenses, net income is calculated. Beside those components,
other comprehensive income is also presented. Other comprehensive income can
include some gains and losses arising from foreign currency translation or the
change in fair values of assets, etc. All are summarized into statement of comprehensive
There are two alternative presentations of the statement: single-statement
or two-statement. A statement of profit and loss combines with other
comprehensive income are presented as a single-statement. A statement of profit
and loss separately with statement of other comprehensive income are called
two-statement. Who decide?
By conceptual Framework
for Financial Reporting, “income is increase in economic benefits during the
accounting period in the form of inflows or enhancement of assets or decrease
of liabilities that results in increase in equity, other than those relating to
contributions from equity participants”. Income involves both revenue and gain.
By definition, revenue is the amount arising from the ordinary trading
activities of the company and be distinguished with gain which is earned from
the peripheral activity.